I posted yesterday about potential GDP being the center of the business cycle and how labor share reflects potential GDP. I want to go a little deeper into this using recent data.

I want to show the difference between potential GDP (the center of the business cycle) and Real GDP's natural limit (the top end of the business cycle).

This first graph shows the capacity utilization cycle in relation to labor share (blue line). Labor share represents the zero line. Capacity utilization rises and falls around its effective labor share center. Then the percentage difference between the two is amplified into the real GDP movements around potential GDP, which is the center of the real GDP cycle. OK... that summarized the previous post.

Now I add a line for the natural limit of real GDP. This is calculated by establishing the price level where the effective demand curve crosses the aggregate supply curve, then feeding that price level into the aggregate supply equation to get real GDP.

The way to read this graph is to see real GDP moving through its business cycle. The zero line is the center of the business cycle (potential GDP). The yellow line and its 4 quarter running average (red line) is the top end of the business cycle. Real GDP expands up to the natural limit and then heads back down into a contraction.

The natural limit (LRAS curve) has been fairly stable around the $200 billion point (2009 dollars). It has jumped up since the crisis which is a function mostly of high unemployment. But the yellow line and the blue line will move toward each other now. The basic story is that real GDP is close to the top end of the business cycle, which is very different than what most economists think.

Why am I different? I have studied labor share and its role in effective demand. I have developed models for labor share as a useful tool in understanding the economy. On the other hand, most economists don't have models for labor share. P. Krugman never even mentions it.

Here are the lines for real GDP, potential GDP and the natural limit of real GDP since 4th quarter 1996.

You can see how real GDP (red line) moves up to the natural limit and then falls back down below potential GDP through the business cycle.

Here is a close-up for the last 7 years.

My definition of the natural limit is what most economists say is potential GDP. When they talk about the output gap, they refer to the difference between the natural limit of Real GDP and Real GDP. They equate potential GDP with the natural limit of real GDP. I distinguish between the center and the top end of the business cycle.